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Adieu, Welfare State? (Int'l Edition)

November 26, 1995

International -- Cover Story -- Europe

ADIEU, WELFARE STATE? (int'l edition)

Often in the past, France has been a crucible of revolutionary change for all of Europe. True to that tradition, the nation in recent weeks has been at the center of what may well be the last great Continental convulsion in this century: the dismantling of the welfare state. For days, workers have poured into Paris streets to protest planned cuts in medical and pension rights. A few weeks earlier, an angry mob of shopkeepers firebombed a Bordeaux tax office to vent their rage over social levies that are driving many of them out of business.

For far longer, this latent crisis has been rattling the European Union's currencies, toppling governments, and straining the functioning of the single market. On Nov. 15, the crisis drew a response that may well determine Europe's identity in the global economy. Prime Minister Alain Juppe moved to reverse the cost of French social policy, which has produced a $47 billion deficit in four years. He bluntly warned rebellious citoyens accustomed to state-sponsored pampering that they'll have to pay more and get less.

So will all of Europe. The welfare state's unchecked growth and sometimes astounding waste have in large part rewritten its original role. Conceived as a gentle guardian against fear and want for millions of Europeans, it now threatens Europe's hopes in the global race for jobs and capital. Welfare spending at its current pace also risks sparking a financial crisis that would send interest rates soaring and fracture currency and bond markets. And though many Europeans are loath to admit it, the welfare state's drain on economic growth is creating an underclass of unemployed, politically volatile citizens.

High stakes indeed. There's no guarantee that Juppe or Europe's other leaders can succeed. The welfare state has proven so resilient that in recent years, voters in the Netherlands and Sweden have dumped governments that dared to undertake fundamental reform. It's not hard to see why. In Europe, far more than in the U.S., the welfare state is synonymous with the economy itself. Government programs fund retirements, generously compensate jobless workers, finance health care, and subsidize unprofitable industries. In the past half-century, Europe has looked upon the welfare state as one of its proudest achievements. So ingrained is the system that workers see their five-week vacations, subsidies for large families, and even free ski schools for kids as basic human rights.

The harsh reality is that fixing the welfare state will require a painful dismantling of Europe's approach to economics and social welfare. That means more deregulation of the marketplace and the injection of more market dynamics in administering social programs. It also means more of some distinctly un-European realities--an acceptance of low-paying service jobs, a wider income gap, and greater individual freedom over the direction of pension investing and social-program spending.

TRADER RULES. No politician wants to be first to take back the welfare state's privileges. Yet it's clear there's no other choice. Europe's agenda for a planned monetary union this decade will dissolve without a smaller social net and lower budget deficits to satisfy nervous global investors and currency traders. More important, the global competitiveness of European industry hinges on skimpier social protection that will lighten tax burdens and strip away many of the work regulations that are hobbling European businesses.

At the moment, for example, tiremaker Michelin is losing sales because by law, all French factory workers must get Sundays off. New foreign investment in Germany has plummeted as companies build factories elsewhere to avoid Germany's huge tax burden and social levies. Jan Timmer, chairman of Philips Electronics, puts it bluntly: "You have to be scared about the future of Europe as an industrial power."

Faced with these challenges, many European leaders have argued that the rest of the world should change, not Europe. But efforts to jawbone other countries into offering greater social protection or blocking imports from "socially backward" countries have failed. Europe's policymakers also know that the outside pressure to change will just increase, especially with the U.S. bearing down on its own spending. "Europeans don't like [U.S. House of Representatives Speaker] Newt Gingrich," says Edward Yardeni, chief economist for C.J. Lawrence, Morgan Grenfell Inc. "He is the Angel of Death for the social welfare state, not only in the U.S. but worldwide." Indeed, "even our social-security systems have to compete," says Andre Levy-Lang, chairman of the management board of France's Compagnie Financiere de Paribas. Europe's leaders are only now realizing the truth of that.

Of course, for the past several years, policymakers have been quietly taking an occasional nip out of spending, hoping to preserve the welfare state essentially intact. France's previous administration managed to force the French to work 21/2 more years to qualify for full pension benefits. And the Bonn government plans to whittle down a massive, $5.4 billion annual subsidy for the uncompetitive German coal industry.

But the gradualist approach just isn't closing the gaps fast enough, especially given Europe's sluggish growth. As the population ages, pension demands will swell between 2000 and 2030. Net debt in Germany and France is expected to more than double, to 105% of gross domestic product, and in Italy, it's expected to rise to 145%. In the Netherlands, disability payments are costing $16 billion as employers park superfluous workers in disability programs.

These giant bills have prompted governments to do what has always been more expedient in Europe: raise taxes. For example, 70% of the gains from a three-year-old austerity drive in Belgium have come from higher taxes, including plans for a new levy to cover an additional $1.5 billion in social-security and other government expenditures. In Germany and Sweden, governments have put through new levies to fund social programs, including new long-term nursing-care facilities. With industries shifting employment abroad, the new tax burden falls most heavily on the economic agents who cannot move--ordinary consumers. The Juppe government has already boosted the value-added tax by two full points, to 20.6%. If Europeans stay with this pattern too long, writes Swedish economist Assar Lindbeck, they run the "risk that the welfare state will destroy its own economic foundations."

Look no further than Germany for a sense of what Europe's future will be like. Tax-bilking has become the fastest-growing national sport, now costing federal, state, and local governments more than $70 billion in lost revenues annually, by some estimates. To dodge a stiff withholding tax on interest income, savers are stashing away billions of marks in havens such as Luxembourg and Switzerland. German authorities have begun a series of high-profile investigations in search of tax evaders, hitting the likes of tennis star Steffi Graf, to stanch the flow.

Europe's smartest technocrats have seen the disaster coming. Some of their white papers for fundamental reform are actually being dusted off and put into practice. In the Netherlabds and Sweden, deregulation of many industries is intended to get the government out of commerce and unleash new growth to create jobs.

Privatizing part of the government pension programs could also help avoid the bankruptcy of many of Europe's social-security systems. In Italy, the technocratic government of Lamberto Dini has pushed through pension-reform plans that could save up to $60 billion over the next 10 years. For the first time ever, private pension arrangements could come into wide use under the new scheme.

Yet it will be supremely difficult politically to shave the 25% or so in welfare-state costs that would restore Europe's competitiveness and return nearly a half a trillion dollars to the private economy. The idea of "acquired rights" is so deeply embedded in the European consciousness that ordinary citizens find life unimaginable without them.

Predrag Grcic symbolizes the conflict between what Europe needs and what it wants. Standing in line at a Brussels unemployment office, the soft-spoken 24-year-old admits that he has never worked at anything other than odd jobs. After four years at college, he now waits to begin a career as a social worker. He can afford to be patient. The jobless benefits that Brussels guarantees each citizen from age 18 until retirement--in his case, $643 a month--mean he can turn down a job doing manual labor, which he derides as "badly paid and degrading."

DIFFERENT VIEW. Voters such as Grcic will never want to relinquish these rich goodies. In France, the opponents of Juppe's reforms even want to increase benefits. Marc Blondel, head of one of France's largest civil-service unions, advocates a change in mandatory vacations from five weeks to six to create more jobs. Frederic Bonnot, 23, a member of a large student union, has been marching off and on all year to protect the welfare state. He helped scuttle government plans to reduce by 20% the minimum wage that employers could pay low-skilled workers just out of school. Bonnot doesn't care that the French minimum wage was just increased by 4%, to 5,000 francs a month. He won't be happy until the minimum wage goes to 7,000. "That would enable people to live decently and have some sort of leisure," he says.

And the extraordinary generosity of Europe's traditional pension plans makes Europeans understandably reluctant to part with them. Consider Beatrice Gazzelloni. The 41-year-old Roman is one of millions of Italian "baby retirees" who choose to take advantage of the Italian social net and retire early. A former assistant at the Ministry of Public Education, Gazzelloni decided last year to forgo her $1,250 monthly salary. She now lives on her $625 monthly pension check and an additional $935 she earns as a part-time sales assistant in an antique store. She's not complaining. "I knew I was eligible for my pension, so I thought, why not just retire?" says Gazzelloni. "It was my ticket to a better life."

Politicians somehow have to convince Europeans such as Grcic, Bonnot, and Gazzelloni that these privileges can no longer be part of the European lifestyle. Such a fundamental reversal in mind-set may ultimately take generational change. So far, Europe's weak leaders have done little to uproot the sense of cultural superiority Europe has over the U.S. because of the welfare state's benefits and because of the obvious failures of some U.S. policies. Efforts to inject more market-driven methods of administering health, pension, and other benefits programs always prompt the opponents of reform to conjure up visions of homeless Americans and others who have fallen through the safety net. Peter Praet, chief economist at Belgium's Generale de Banque says the "U.S. alibi" serves as a powerful argument against reform.

The challenge for Europe's politicians is to convince voters that muddling through is a far more dangerous course than a determined reform effort. The alternative is an economic weakening that will soon begin to undermine much of Europe's postwar economic progress (table, page 68). In Germany, for example, even government officials agree that taxes are at their limit. Further tax and contribution increases will "damage the German economy's ability to invest and grow," worries Jurgen Echternach, state secretary at the Finance Ministry in Bonn. "The negative consequences for employment and the labor market would be incalculable."

EXODUS. As German companies have sought to escape high interest rates, a strong mark, and the burden of payroll taxes that fund social-insurance programs, they have discovered low-cost alternatives for new factories around the world, from Alabama to Poland to Indonesia. Last year, Germans poured $20.5 billion into direct investment abroad while foreigners sold off $3.5 billion of industrial investments in Germany.

Other companies are also seeking their fortunes elsewhere. Across Europe, a recent survey found domestic employment levels expected to remain static or fall in 74% of western European manufacturing companies. Some 55% are looking to fight competition by creating jobs overseas. "European companies will continue to vote with their feet without fundamental changes" to social programs, says Michael J. Fradette, senior partner at manufacturing consultant Deloitte Touche Tohmatsu International, which conducted the survey.

Fradette predicts that Germany, France, Britain, Italy, and Sweden will lose as many as 4.5 million additional jobs over the next five years as companies are forced to go offshore to obtain higher productivity and lower costs. That's 4.5 million workers who could end up on the welfare rolls unless something drastic happens. Such joblessness would add more hundreds of billions to welfare-state costs in outright payments and lost tax revenues.

Reformers may have less time than they think to turn the welfare state around. Many analysts expect the next whiff of economic downturn will push Europe into a new phase of crisis. The next European recession will spark a steep drop in tax revenues, which in turn would expand budget deficits dramatically. Such a scenario would likely kick off a disastrous spiral of rising interest rates and collapsing bond and currency prices. No doubt that would spell the end of the European Union's single-money dreams. Europe's more profligate spenders, such as Italy and Sweden, would be likely to get hit first.

YOUNG VS. OLD. But the threat from such a scenario goes beyond the issue of a future European Union designed on the idea of converging--not diverging--economies. As Europe's second-tier economies deteriorate, there will be growing generational strains as younger, active workers resist paying the levies and taxes required to sustain entitlements.

While no one suggests that Europe's fragile social consensus could support U.S.-style capitalism, the task of fixing the welfare state does mean more American-style deregulation and a market dynamic in administering social programs. In France, for example, citizens may have to accept limits on the number of reimbursable doctor visits they can make and on luxuries such as subsidized visits to seawater-therapy clinics. Such practices contributed to last year's health-insurance deficit of $6.3 billion.

Innovative reforms are being tried (box). With greater deregulation and lower payroll costs for employers, the workplace will change dramatically. More jobs will be created--but mostly in the service sector, in everything from discount retailing to sophisticated financial services to software programming. There will be a much greater range in incomes and greater individual responsibility in managing everything from pension investments to unemployment benefits. A case filed with Germany's supreme court argues that citizens should have the right to opt out of the welfare system for both benefits and deductions.

Europeans will have to readjust their attitudes to U.S.-style low-paying service employment they frequently deride as "hamburger-flipper" jobs. In Germany, at a minimum, "somebody has to tell 2 million people that they will never work outside a low-paid service job," says Kurt Kasch, senior vice-president at Deutsche Bank. "The politicians say that's right. But no one dares tell the public."

A COMPROMISE. Dennis Snower, a respected welfare-state economist at Birkbeck College in London, also senses that "Europe simply needs to have more imagination about overhauling the welfare state." His prescriptions include a plan that would move the long-term jobless back into the workforce by allowing them to keep their unemployment benefits while taking entry-level jobs. He also argues for giving middle-class recipients the option of relinquishing lifelong entitlements in return for one-time bonuses of cash or other rebates that the state would issue at a fraction of the existing welfare-benefit cost.

Fundamental welfare reforms, however, will also carry risks. It's easier to hack at programs for the poorest than to try to wean more politically active middle-class users off their benefits. But that approach feeds what Andre Sapir, head of the Institute for European Studies at the Free University in Brussels, calls "the growth of a European permanent underclass." Under the current welfare state, the numbers of the excluded and disenfranchised are already growing. Brutally yanking away most of the benefits for the jobless could drive more of them to the protectionist, xenophobic fringe that has been the hallmark of European politics for the last several election cycles.

By and large, most Europeans confine their feelings about the welfare state to a vague presentiment that something is wrong--but that no one should attempt the painful task of reform. "It's a lot like the Soviet syndrome," says Belgian economist Praet. "Not only in the way it operates, but in the feeling that it is not going to change." But we all know what happened to the Soviet Union. Europe, take note.

Taming the Welfare State

The struggle to cut spending for Europe's four big economies

GERMANY

THE PROBLEM

The system needed a $77 billion boost in extra taxes and social-security deductions from 1991 through 1995 to stay solvent. Annual health-cost increases of 6% are overwhelming spending caps.

REFORMS TO DATE

Retirement age has been pushed back, and employees will work one extra day a year to help finance nursing-home care.

PROGNOSIS

Massive pension reform is still desperately needed. After 2010, deductions to meet monthly payouts will be unacceptably high.

FRANCE

THE PROBLEM

Unfunded pension liabilities are more than double GDP. National health care ran a $6.3 billion deficit last year.

REFORMS TO DATE

French must now work longer to qualify for maximum pensions. Taxes are rising to stem social-security deficits.

PROGNOSIS

Public-sector unions are stonewalling all but the most cosmetic reforms.

BRITAIN

THE PROBLEM

Social-security budget has jumped 35% since 1989. Spending cuts are raising political, racial, and social tensions.

REFORMS TO DATE

Qualifying criteria for disability benefits have been tightened. Many workers are opting for partially privatized pensions.

Public debt is the biggest in Europe--$1.3 trillion--and unfunded pension liabilities already amount to 100% of GDP.

REFORMS TO DATE

The Dini government has pushed through a pension reform that could save $60 billion through 2005.

PROGNOSIS

Despite good pension reform, system may still not support a rapidly aging population.

DATA: EUROSTAT, BUSINESS WEEK

Two Paths for Europe

Britain's Oxford Economics has prepared two scenarios that show what might

happen if major EU members slash spending and deficits to 3% of gross domestic product by 1999--and what could happen if they don't.

1. BIG DEFICIT CUTS ACROSS THE EUROPEAN UNION

Germany, France, Britain, Italy, and Spain meet the Maastricht deficit target of 3% of GDP by 1999. The payoff is steady growth, modest inflation, and stable interest rates. Bigger winners are the debt-ridden Italians and Spanish, rewarded with faster growth and sharply lower inflation and interest rates. France also wins a 1.8% inflation rate and 6.9% yields on government debt. But it suffers from a sluggish economy and continued unemployment of 11% as the price of building a foundation for a more stable economy. The bottom line for the EU: moderately higher GDP growth, reaching 2.6% by 2001.

2. SOME DEFICIT CUTS, BUT NOT ENOUGH

Germany and Britain already have enacted measures to ensure that they'll meet the 1999 target. France delays cutting deficits until 1998, buying itself faster growth and lower unemployment for a while. But there is a big cost in higher inflation and interest rates. Italy and Spain, meanwhile, fail to reach the deficit goal. They are penalized with long-term interest rates above 9%, significantly higher inflation, and slower growth. Around the EU, growth slows to 2.5% by 2001.

DATA: OXFORD ECONOMICSBy Bill Javetski in Paris, with John Templeman in Bonn, Linda Bernier in Brussels, John Rossant in Rome, and bureau reports